Carl Reader of The Franchising Handbook: can you really afford that franchise?

Before buying a franchise, it’s worth considering what exactly you’re paying for and, just as importantly, whether you can afford it, says Carl Reader in The Franchising Handbook.

One of the key things to consider when looking at a franchise is the affordability of the initial franchise fee and associated startup costs, such as working capital and any stock or assets that are required to get the business off the ground. In fact, in my experience, this is usually the main limitation that most franchisees have and plays a huge part in the selection process.

I’m fairly confident that a vast number of franchisees spend as much as they can afford – both through personal and external funding – so being clear on affordability levels is vital when starting to consider your options in franchising.

Understanding the principles of funding

Even if you are able to fund the entire startup costs of the franchise personally, it may be preferable to source external funding for a proportion of the costs. But, before you even attempt to gauge how much you can afford, it’s important that you fully understand the basic principles of external funding.

In particular you should consider both what the banks would look to receive from you and how much they would be prepared to fund you in the new venture. The general rule of thumb for financing a franchise is that the banks will lend up to 70% of the initial capital requirement for an established, successful brand.

Advertising of initial franchise costs

One of the areas where you will need to proceed with caution is in respect to the figures advertised by franchisors as the initial cost. From a franchisee’s perspective, this is one of the challenges raised by the fact that the industry is unregulated.

The only exception to this is the Code of Ethics that is voluntarily adopted by all bfa-member franchisors. Section 3.1 of the bfa’s Code of Ethics states: “Advertising for the recruitment of individual franchisees shall be free of ambiguity and misleading statements.”

Whilst this means that any advertising must be free from factual misstatement – such as advertising the franchise fee as £10,000 when it is actually £15,000 – it does not dictate how the initial investment should be disclosed, if at all, nor does it state how this figure should be calculated.

Prospective franchisees should therefore consider whether any amounts quoted are for the franchise fee only, the franchise fee plus required purchases from franchisor or if they include additional working-capital and asset-purchase requirements to start trading.

Funding requirements over the initial franchise fee

The working-capital requirements of a business depend on many things, not least the type of company that you are running and the nature of the cash flows within that business. Broadly, there are two different types of funding required above the initial franchise fee.

Asset funding

For most franchises, particularly those outside of the home-based, business-to-business sector, there will be a requirement to purchase some assets. This requirement might simply be for an initial stock of items – for example, a football-tuition franchise might be required to only purchase some footballs and children’s football kits. However, this will often be a wider ranging requirement. Depending on the type of sector, you may be required to fund the purchase of items such as shop fittings, kitchen equipment, vans, tools and computer systems.

Working capital requirements

The other funding requirement over the initial franchise fee is working capital. Every business has some form of working-capital requirement, which is simply to fund the time between work being commenced and a customer paying for its completion. The working-capital requirements can be established from a business plan and will form part of the funding requirement of the company.

Payback period

One of the things that you should consider when looking at affordability – and ultimately appraising the investment – is the payback period for the franchise investment. Whilst the payback period varies depending on the type of franchise, the level of head-office support and, most importantly, the input that you put into the business, it is still a metric that you need to consider.

Generally speaking, the payback period on a management franchise would be longer than the payback on an owner-operator franchise. This is because you, as the franchisee, are effectively subsidising the business for the cost of labour for actually doing the job.

As this period can vary from franchise to franchise – and can ultimately be dramatically affected by your own business performance – I wouldn’t get too hung up on this statistic. However, I certainly would look to acknowledge this within your projections and be aware of the payback target for your investment.

Personal risk appetite

Another area that you need to take into account is your appetite for risk. As mentioned above, the banks want to see that you have taken an impartial and informed view of the risks involved in running the business. And, perhaps more importantly, they want to make sure that you share the risk with them. Every funder will be looking for you to have some skin in the game and this would ordinarily be through a combination of personal funding, security over assets and the right motivation to grow the business.

On the face of it, a larger investment will carry a larger risk because the security over personal assets and the initial capital requirement from you personally will be greater. You also need to consider the risk of the franchise itself. Clearly an investment in a well-established, successful brand such as McDonald’s – although higher in terms of pounds invested – should be a safer bet than a franchise that hasn’t been set up properly, nor tested through a pilot operation.

Only you will be able to decide the right level of risk that you are satisfied to accept and again it comes back to the key skill of separating your emotions from the logic of deciding whether to purchase the franchise.

The above is an exclusive and abridged extract from The Franchising Handbook by Carl Reader. The book is due to be published on July 14 and will be available from Amazon and all major bookstores.